Commentary

Everyman’s hedge funds aren’t worth it

Commentary: Funds of hedge funds have a dismal record

Hedge funds — traditionally the province of wealthy investors — are increasingly available to the public via mutual funds that invest in hedge funds or follow hedge-fund-like strategies.

The number of such mutual funds has mushroomed in recent years. Fund tracker Lipper counts 409 offerings in its “absolute return” category, which contains funds that seek “positive returns in all market conditions.”

That is over four times more than just two years ago. Many of the funds have minimum investments as low as $1,000, whereas hedge funds often require at least $500,000 or more.

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Funds of hedge funds have a dismal record, according to Mark Hulbert’s research.

If history is any guide, however, you will be better off investing in low-cost index funds.

It’s easy to understand the allure of hedge funds, even though they charge high fees — typically 2% of assets and 20% of profits. (Funds of hedge funds tack on additional fees.) Hedge funds supposedly pursue complicated strategies that do well whether markets are going up or down.

Yet the average hedge fund has done no better than the stock market since the October 2007 bull-market high. The Dow Jones Credit Suisse Hedge Fund index, encompassing nearly 8,000 funds, produced a 3.3% annualized gain over this period, versus 3.4% for the Wilshire 5000 Total Market index, which reflects all U.S. stocks, including dividends.

The real picture might be even less flattering, since hedge funds often invest in other asset classes besides U.S. equities, such as bonds and commodities. The investment-grade U.S. bond market, for example, as judged by the Vanguard Total Bond Market Index Fund, has produced a 5.9% annualized return since October 2007. Gold bullion has gained 13% annualized.

A fairer comparison might be with all mutual funds and exchange-traded funds, regardless of investment focus. According to Lipper, the average annualized return of all funds they follow was 5% from October 2007 through the end of April — 1.7 percentage points a year higher than the average hedge fund.

To be sure, the typical hedge fund did provide some downside protection during the 2007-09 bear market. In contrast to the Wilshire’s 39% annualized loss, the Dow Jones Credit Suisse Hedge Fund index lost an annualized 12%.

But since the bull market began in March 2009, the average hedge fund has lagged behind the Wilshire by more than 14 percentage points a year.

Even if you thought that trailing the bull market by this much is an acceptable price for the downside protection, you should know you can get that protection at a much lower cost by investing in index funds.

Since October 2007, a portfolio invested 60% in a stock-market index fund and 40% in a bond-market index fund has beaten the average hedge fund by 1.9 percentage points a year, with no more downside risk or volatility, according to the Hulbert Financial Digest.

You might discount this result on the grounds that the period since the October 2007 high is unique and unlikely to be repeated in the future. Yet the same conclusion emerges when focusing on the past decade.

To be fair, these results reflect a broad hedge-fund index, and some funds have done much better. A few have performed spectacularly. But the proportion of hedge funds making enough to justify their high fees is very small, according to David Hsieh, a Duke University finance professor who has studied hedge-fund performance.

In one study, he compared each of several hundred equity hedge funds to a control portfolio designed to have the same risk profile but owning only index funds and other widely available investments. He found that only one out of five did better than its corresponding control portfolio. What’s more, Hsieh says, it is nearly impossible to identify in advance these select few hedge-fund managers who do add value.

In another study, Hsieh examined funds of hedge funds, which invest in individual hedge funds. He found that just 2% of them earned more than enough to justify paying their fees.

If funds of hedge funds have such a dismal record, despite having full-time staffs to analyze hedge funds, what makes you think you can do any better?

Hsieh cautioned that these results might paint an unfairly negative picture. That is because the proportion of hedge-fund managers who have genuine ability, while low, still is higher than among mutual-fund managers.

Nevertheless, the same investment lesson emerges regardless of whether only a small minority of hedge funds, or none, are able to consistently beat the market: Invest in index funds.

If a 100% stock allocation seems too risky, then allocate some of your portfolio to more conservative assets, such as bonds. Among the lowest-cost ways to invest in the stock and bond markets are the Vanguard Total Stock Market Index Fund, which tracks the Wilshire 5000 index and charges an expense ratio of 0.17%, or $17 per $10,000 invested, and the Vanguard Total Bond Market Index Fund, which is benchmarked to the Barclays U.S. Aggregate Float-Adjusted index and charges 0.2%, or $20 per $10,000 invested.

If you still want to dabble in hedge-fund-like strategies, the top-performing open-end mutual fund in the absolute-return category over both the last one- and three-year periods, Lipper says, is the AmericaFirst Quantitative Strategies Fund, with an expense ratio of 2.27%, or $227 per $10,000 invested.

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